Often, the only unencumbered assets left after a company goes bankrupt are potential causes of action against deep-pocketed professionals that witnessed or contributed to the debtor’s demise. Of course, it’s one thing to allege misconduct; proving it (as noted here) is a horse of a different color. A trilogy of recent decisions from the 7th Circuit Court of Appeals, however, demonstrates the increasing impatience of courts with plaintiffs who, as the 7th Circuit’s Chief Judge Frank Easterbrook recently put it in one of these cases, sue the debtor's professionals in an “attempt to find a deep pocket to reimburse investors for the costs of managers’ blunders.” HA2003 Liquidating Trust v. Credit Suisse Secs. (USA) LLC, 517 F.3d 454 (7th Cir. 2008) (pdf)

The latest failed effort is found in a decision authored by Judge Diane P. Wood, as compassionate and fair–and inspirational!–a judge as you’ll find (and possibly the next Supreme Court justice), in Joyce v. Morgan Stanley & Co., Inc., 2008 WL 3844111 (7th Cir. 8/19/08) (pdf). In this case, Morgan Stanley, once the advisor to RCN, was engaged by 21st Century Telecom Group in late 1999, just before the telecom industry busted, to serve as 21st Century’s financial advisor in an ill-fated stock-for-stock merger with RCN. As part of its engagement, Morgan Stanley delivered a “fairness opinion” to 21st Century’s board. Between the 12/12/1999 date of the merger agreement and the 4/28/2000 effective date of the merger, RCN’s stock price plummeted and 21st Century’s stockholders ended up left holding the bag.

Nobody, however, leaves Ed Joyce–a famed Chicago commercial litigator–holding the bag and gets away with it, at least not without a good fight. The problem for Ed, however, was finding a deep pocket to compensate him and his fellow stockholders for their losses, not an easy task particularly since they first filed suit more than six years after the merger’s effective date. In their one-count complaint, which alleged “constructive fraud” on the part of Morgan Stanley, Ed and his fellow plaintiffs argued that Morgan Stanley had a duty to advise 21st Century’s shareholders about how to minimize their exposure to a potential drop in RCN’s stock price following execution of the merger agreement. Morgan Stanley didn’t, they alleged, because that would likely have caused RCN’s stock price to decline. Further, they alleged, Morgan Stanley didn’t want that to happen because of its conflict-of-interest stemming from the fact that it had served as RCN’s financial advisor before the merger.

Judge Wood, together with Judges William J. Bauer and Terence T. Evans, agreed that Ed and the other shareholders had standing to sue because their claims were direct, not derivative. That’s all they agreed with, however. While everyone recognized that in order to tag Morgan Stanley with liability, Morgan Stanley had to owe the 21st Century shareholders a fiduciary duty, here’s where the wheels fell off the bus because the 7th Circuit would not agree that Morgan Stanley owed the 21st Century shareholders a duty of full and fair disclosure. To the 7th Circuit, the duties of Morgan Stanley were rooted in its engagement agreement, and no extra-contractual fiduciary duty existed to require Morgan Stanley to advise the 21st Century shareholders about hedging strategies that might minimize their exposure to fluctuations in the value of RCN stock. Judge Wood wrote:

The exhibits leave no doubt that Morgan Stanley did not accept any such responsibility, and so no fiduciary duty toward the Shareholders ever arose. The engagement letter, which defines the advising relationship, explicitly noted that Morgan Stanley was working only for the corporation: “Morgan Stanley will act under this letter agreement as an independent contractor with duties solely to 21st Century.” (Emphasis [in opinion]). “We have acted as financial advisor to the Company in connection with this transaction....” (Emphasis [in opinion]). The fairness opinion also disclaimed a duty to the Shareholders:

It is understood that this letter is for the information of the Board of Directors of the Company, except that this opinion may be included in its entirety in any filing required to be made by the Company in respect of the Merger. Morgan Stanley expresses no opinion as to the relative valuations of each of the voting and non-voting 21st Century Common Stock and the 21st Century Preferred Stock. In addition, this opinion does not in any manner address the prices at which the RCN Common Stock will trade following announcement or consummation of the proposed Merger, and Morgan Stanley expresses no opinion or recommendation as to how the holders of the 21st Century Common Stock should vote at the shareholders' meetings held in connection with the Merger. (Emphasis [in opinion]).

Thus, Morgan Stanley never owed any contractual nor extra-contractual duty to the Shareholders. We rejected a similar claim in HA2003 Liquidating Trust v. Credit Suisse Secs. (USA) LLC, 517 F.3d 454 (7th Cir. 2008) (pdf), where we observed that investment banks' responsibilities are set by contract; the fact that someone wishes that a different contract had been written is not a basis for liability. Id. at 458-59. (Emphasis added in this post).

In addition to the explicit disclaimers we have highlighted, the conflict waiver clauses reinforce the fact that Morgan Stanley did not accept a duty toward the Shareholders. It required 21st Century to waive all claims based on conflict of interest but made no mention of the Shareholders: “21st Century agrees that it will not assert any damage, conflict of interest, or other claim against us, our affiliates or such other party arising out of our relationship with RCN on the basis of a conflict of interest or otherwise.” “[B]oth RCN and 21st Century have waived any potential conflict of interest.”

Despite all these explicit disclaimers of a duty to anyone but 21st Century, the Shareholders argue that Morgan Stanley's unsuccessful attempt to negotiate a price protection feature into the stock-for-stock sale of 21st Century to RCN demonstrates that it had voluntarily accepted a fiduciary duty to look out for the stockholders' interests. This is not enough; we are not aware of any authority to support the proposition that an attempt to facilitate an outcome that would benefit a party automatically makes the attempter a fiduciary of that party.

Judge Wood’s citing of Chief Judge Easterbrook’s opinion in the HA2003 case is important. In that case, the post-confirmation liquidating trust for HA-LO Industries, once the world’s greatest maker of promotional “chatchkies,” sued Credit Suisse First Boston (CSFB), HA-LO’s investment banker, for gross negligence in failing (i) to reject the HA-LO board’s wildly inflated projections of a “dot.com” target in a $240 million acquisition and (ii) to withdraw or modify (i.e., “bring-down”) its opinion to the May 2000 merger effective date following the bursting of the “dot.com” bubble in April 2000.

Chief Judge Easterbrook wrote that it was not clearly erroneous for the district court to have “found it impossible to label as ‘grossly negligent’ CSFB's decision to do what the contract required it to do: use the figures and projections furnished by its client.” HA2003, 517 F.3d at 456 (emphasis in original). Like Judge Wood in Joyce, Chief Judge Easterbrook pointed to the primacy of contract in these types of cases, writing:

CSFB followed the norm in this business-more to the point, it followed the rules in its contract with HA-LO-and relied on management's numbers. It told HA-LO to hire someone to check those numbers. Separating number-creation from number-evaluation is not illegal and may make business sense. The division of labor between number verifiers (Ernst & Young) and number crunchers (CSFB) is not to be sneezed at; the division of labor has large benefits for an economy, as it allows specialists to do what they are best at.

After Ernst & Young told HA-LO that its expectations about the Starbelly.com technology and prospects were wildly excessive, HA-LO stuck to its guns. It can't blame that on CSFB. This suit is nothing but an attempt to find a deep pocket to reimburse investors for the costs of managers' blunders. Cf. Fehribach v. Ernst & Young LLP, 493 F.3d 905 (7th Cir. 2007) (pdf),[discussed in this post]. But CSFB did not write an insurance policy against managers' errors of business judgment. Compelling investment banks to provide business-risks insurance as part of a fairness opinion would just make investors worse off, as that would increase the price of each opinion. Investors would pay ex ante for any benefit received ex post-and the bar would pocket a substantial portion of the transfer payments. Insurance is cheaper (free, really) when achieved via the stock market. Investors can diversify their holdings; then when acquir ing firms, such as HA-LO, overpay in an acquisition, investors gain in their role as shareholders of the acquir ed firms. Diversification protects investors without the costs of insurance and litigation….

And, to repeat, CSFB undertook to deliver an opinion as of one date. Updates require extra work, which must be paid for. HA-LO's managers not only did not offer to pay CSFB for an updated opinion but also, as the parties stipulated, decided not to request such an opinion even if CSFB had been willing to render one for free.

In the end, the Trust wants us to throw out the detailed contract that HA-LO and CSFB had negotiated and to make up a set of duties as if this were tort litigation. That would be a mistake, one very costly for investors at other firms who would have to pay a risk premium to investment bankers in the future. Intelligent adults can set their own standards of performance, and courts must enforce the deal they have struck. See Wallace v. 600 Partners Co., 86 N.Y.2d 543, 634 N.Y.S.2d 669, 658 N.E.2d 715 (N.Y. 1995). The engagement contract says that CSFB has no duty to double-check the predictions about Starbelly.com's future revenues and no duty to update its opinion. CSFB did what it was hired to do. The Trust's belief that CSFB should have been hired to do something different is not a basis of liability.

The 7th Circuit’s recent trilogy of cases (Joyce, HA2003, and Fehribach) all absolve a client’s professionals from any duties not specified in their engagement agreements, and thus are required reading for those “attempt[ing] to find a deep pocket to reimburse investors for the costs of managers’ blunders.” HA2003, 517 F.3d at 457 (citing Fehribach). The plaintiffs' attorneys in Joyce should at least be thankful that Judge Wood didn’t take the next step, as Judge Richard A. Posner did earlier this year (in an opinion joined by Judge Wood and Chief Judge Easterbrook) in Maxwell v. KPMG LLP, 520 F.3d 713 (7th Cir. 2008) (pdf), when he encouraged KPMG’s counsel to consider fiing a sanctions motion against the trustee and its counsel (which KPMG nearly did against the trustee, to the tune of $4 million, thus prompting this quick settlement of the underlying action, and actually did–successfully so–against the trustee's counsel to the tune of $234K for filing a frivolous appeal) after having scolded the trustee and its counsel for having initiating a frivolous suit seeking an astronomical $626 million in damages. The fact that the Joyce plaintiffs weren’t litigation trustees (who, Judge Posner wrote, “ha[ve] little to do besides filing claims that if resisted he may decide to sue to enforce”) may have saved them from a similar fate. Id. at 718.

So, here we are, in 2008, finally resolving claims that arose from the bursting dot.com bubble of 2000. Apply that same resolution rate to unresolved contests arising from today’s bursting housing and credit bubbles, and we just might see some finality by the opening ceremonies for the 2016 Olympic games (in Chicago, we hope!).

Thanks for reading.

***

8/26/08 Update: Turns out that Judge Posner's panel in the Maxwell v. KPMG case issued this order, also on 8/19/08, imposing sanctions against the bankruptcy trustee's counsel for initiating a frivolous appeal. Having found that sanctions were warranted, and that KPMG's counsel's fees were reasonable, the Court considered the question of "who should pay the sanction?" The Court said it was "disinclined to impose sanctions on the bankrupt estate," and instead considered "whether Maxwell, personally, his counsel, or both should pay the sanction."

Noting the split in the circuits on the applicable standard for holding a bankruptcy trustee personally liable for sanctions, the Court held Maxwell harmless under the standard of the 7th Circuit that imposes personal liability on the trustee "only if he willfully and deliberately violated his fiduciary duties." The Court, however, would not apply the same standard to Maxwell's counsel, stating that "even if counsel subjectively believed this appeal had merit, ... it does not insulate them from liability for sanctions." The Court emphasized that "an appellant's belief that cases the district court relied on in ruling against him do not apply is not an excuse for failing to explain to this court why they do not apply." (Emphasis in original). Further, the Court distinguished between the standards applicable to sanctions imposed for initiating a frivolous case and those for filing a frivolous appeal, stating:

Counsel also argues that the decision to file a complaint against KPMG was an informed decision reached after reasonable investigation and expert consultation, but argument concerning the decision to file the complaint should be made to the district court. Counsel does not maintain that any expert consultation informed their decision to take an appeal.